Options Illiquidity: Determinants and Implications for Stock Returns

55 Pages Posted: 7 Sep 2014 Last revised: 8 Nov 2015

See all articles by Ruslan Goyenko

Ruslan Goyenko

McGill University - Desautels Faculty of Management

Chayawat Ornthanalai

University of Toronto - Rotman School of Management

Shengzhe Tang

University of Toronto - Rotman School of Management

Date Written: October 31, 2015

Abstract

We study the determinants of options illiquidity measured with relative bid-ask spreads of intraday transactions for S&P 500 firms over an extended time period. We find that market makers' hedging costs significantly impact options illiquidity with the future rebalancing cost dominating the initial delta-hedging cost. Inventory demand pressure and adverse selection also contribute to variations in options illiquidity, with the latter effect intensifying around information events. We find option-induced order flows predict their underlying returns only when options illiquidity simultaneously increases. This suggests that shocks to options illiquidity help distinguish abnormal order flows that contain private information from those induced by liquidity trading. We show a simple strategy that uses high-option-illiquidity stocks and yields 16.5% in risk-adjusted returns per year.

Keywords: Market microstructure; Options; Liquidity; Market making

JEL Classification: G12; G14; G24

Suggested Citation

Goyenko, Ruslan and Ornthanalai, Chayawat and Tang, Shengzhe, Options Illiquidity: Determinants and Implications for Stock Returns (October 31, 2015). Rotman School of Management Working Paper No. 2492506. Available at SSRN: https://ssrn.com/abstract=2492506 or http://dx.doi.org/10.2139/ssrn.2492506

Ruslan Goyenko (Contact Author)

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada

Chayawat Ornthanalai

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Shengzhe Tang

University of Toronto - Rotman School of Management ( email )

105 St. George St.
Toronto, Ontario M5S 3E6
Canada

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